The Weak Link Between Economic Growth and Market Returns

When deciding where to allocate your investments on a global basis, it’s tempting to look for the fastest-growing economies and put your money there. Yet academic studies have shown that there’s only a very weak relationship between how fast a country’s economy grows and how well its stock market performs.

It may seem counterintuitive, but sometimes stock markets in countries with slower economic growth significantly outperform those in faster growing countries. This year is a a prime example. The latest World Economic Outlook from the International Monetary Fund estimates that China’s economic growth this year will be 7.6% while Japan’s will be only 2.0%. With the year almost over, Chinese stocks are roughly flat while Japanese stocks are up more than 20% (in U.S. Dollar terms).

Why don’t faster-growing economies also mean faster-rising stock prices? Part of the answer is that since economic growth can be estimated fairly well in advance, expectations for faster growth may already be incorporated into stock prices. In other words, if you know that one country is going to grow faster than another, it’s likely that someone else figured that out before you did.

Another reason is that some aspects of economic growth may hurt many companies rather than help them. New technological innovations can boost a country’s economic growth rate, for example, but the profits from these innovations could go to new start-ups more than the existing large companies that tend to be listed on stock markets.

The upshot is that pouring money into fast-growing countries (or completely avoiding slow-growing ones) isn’t a good investment strategy. Having a portfolio that’s well-diversified internationally is a better alternative.